HPG [O-PF +11.2%] – Yuan Devaluation Weighs on Steel Margin

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HSG [Non Rated] - Dream of Competing With HPG & Formosa

September 10, 2015.

Hoa Phat Group (HPG), Steel producer

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We lower TP by 4% as Yuan devaluation weighs on steel margins and construction steel price fell by 7% over July & August. We also deduct from the TP, VND 770 per share amounting to a provision for the agri business.

Yuan devaluation totalling 2.9% during 8M15 is expected to amplify competition in Viet Nam steel sector and slightly outweighs the support from vigorous infrastructure & real estate sector, therefore, we lower our earnings forecast for 2016 by 3%.

Nevertheless, HPG is trading at a PER of 6.3x on our FY15E EPS forecast, a 33.0% discount compared to regional peers.

Robust 1H15A result: HPG’s 1H audited report showed that core NPAT soared by 18% vs. 1H14A on the back of resilient development of steel segment (+18%) as well as all remaining segments (+16%-21%). HPG’s 2Q15A EBITDA margin has surprisingly surged to 23.1% as ASP declined only 3% while production cost declined by ~14% with 6%-28% drop across their input material prices.

Yuan’s devaluation prompts cautiousness forecasting FY16E: We revise down our FY16E earnings forecast by 3% with new ASP assumption of VND10.4m/ton, 3% lower than previous one. As such, for 2016, HPG is estimated to generate lower EPS growth of 9.1 % vs. previous forecast of 13.1% despite sales volume growth of 27% (thanks to the commercial operation of BoF phase 3). We assume 19% EBITDA margin for steel segment under base scenario, 100bps down from 2015’s margin. Of note, a 100 bps change in EBITDA margin results in 8% change in TP.

Strong financial capability to pursue ambitious feed & farm business. On the feed business, an absence of a distribution network is their biggest challenge given CP and Proconco have an established network of 3,000 & 2,000 agents, respectively. HPG envisages 10% market share in the next 10 years, which equals the current third biggest producer in the feed sector being Cargill and minimum IRR of 10-12%. We estimate that the feed business will contribute VND 2,640b in revenue and VND 146b in NPAT for HPG in 2016. Separately, the farming business is not yet incorporated in our modelling given no disclosure. Finally, the maximum loss for the new strategy so far is at VND 500b (VND 770 per share).

Company At A Glance

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SELECT COMPANY METRICS

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Financial Statements

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Quarter Results

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P&L Forecast

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2015 1H Results

HPG reported audited revenue and NPAT of VND13,485b and VND1,888b, respectively for its 1H15A, up 2% and 4% vs. 1H14A on the back of robust 2Q15A profit of VND1,239b (+ 91% vs. 1Q15A).

HPG’s 1H15A core NPAT has grown 18% vs. 1H14A due to solid development of steel segment (+18%) as well as all remaining segments (with growth rate ranging from 16%-21%) except for real estate segment (due to non-contribution from Mandarin Garden project). Lack of revenue from Mandarin Garden also explained for 1H15A flat revenue vs. the same period last year.

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We see that 2Q15A EBITDA margin of steel segment surged to 23.1%, 420bps higher than 1Q15A and it was even higher than 1Q14A and 2Q14A EBITDA margin. Overall, 1H15A EBITDA margin of steel segment averaged at 21.2% vs. 22.3% of 1H14A despite a very challenging environment with steel prices continuously under pressure.

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The impressive margin that HPG obtained in 2Q15A is due to slower decline in ASP (3%) vs. the slump in input material prices including iron ore, coking coal and steel scrap which has plunged from 6% to 28% and led to estimated 14% reduction in HPG’s steel production cost.

Quarter-to-date (10 Sep), we have seen that HPG’s steel price has declined by 7%, even though this is still lower than the production cost decrease of 9% from input material prices dropping from 6% to 15%.

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Rising competition from Chinese steel with Yuan depreciation

Starting from 11 August, China has started a devaluation series of its Yuan, totalling 2.9% for 8M15. However, at this moment, we have not yet seen rising spread between local price and Chinese price. We suppose that this impact will have some lag effects until 2016E.

Nevertheless, the fact that Viet Nam’s construction activities will maintain its vigor in 2016 due to numerous projects in real estate sector as well as infrastructure sector will provide some support for local construction steel price. Of note, Viet Nam’s construction steel consumption has risen significantly, by 24% in 1H15A, the highest pace over the past five years.

HPG currently target to sell their products to large-scale projects including Bach Dang bridge, Da Nang-Quang Ngai highway and Vincom Times City Park Hill in 2016.

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FY16E earnings & target price sensitivity

We run an EBITDA margin sensitivity for HPG and see that earnings will change by 7% while target price will change by 8% with 100bps change in EBITDA margin. Of note, we assume that their sales volume will increase to 1.65m tons (+27% vs. 2015) on the back of the completion of Basic-Oxygen-Furnace phase 3 three months ahead of schedule.

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Animal feed & farm business strategy

  • HPG’s 7-10 year strategy: HPG is on the way to figure out a new business development direction in the future given their ample cash-on-hand as well as a halt to steel business capacity expansion after 2016.
  • Business model: They are doing early steps to follow an integrated agri-food business model (3Fs being Farm, Factory and Food), starting from producing animal feed to pig farming.
  • Where does the strategy come from? This idea originated more than 15 years ago but at the time HPG opted to do steel business first. HPG’s competitive advantage in the feed sector, according to the Chairman, is purely its management administration experience in bulky, heavy and raw products.
  • Target: 10% market share in 10 years, 1m TPA feed animal (equal to current third biggest producer – Cargill), five feed factories, rearing 1m pigs and revenue of VND15-20t by 2020. Investment capital is estimated to be VND8-10t. HPG targets expected net margin of at least 5-10% and expected IRR of 10-12%.
  • Current status: HPG has spent less than VND100b out of VND300b budget on Hung Yen feed factory (capacity of 300,000 tons). They plan to complete the construction by early next year and product launch from Mar 2016. In addition, HPG is preparing to construct another 200,000 TPA feed factory in Dong Nai province.
  • Strategy withdrawal: The management committed that they will withdraw from the new business if returns are lower than their expectations. HPG used to enter into cement production business in 2008 in which they spent VND300b to build and operate a 500,000 TPA cement plant. Seeing returns lower than what they expect, they exited entirely with proceeds of ~VND300b in 2011.
  • Risk: The maximum loss for the new strategy so far is at VND500b given ~100b spent so far and estimated another VND400b spent by 2016. This amount equals to VND770 per share and we deduct this from our target price.

Conclusion: HPG has strong financial capacity to pursue this strategy given the stated capex, given their current net gearing ratio of 0.26x (30 June 2015) and estimated free operating cash flow of VND3.4t p.a during the next five years. Production cost advantage (in which 70% is input materials) is unknown but HPG is notable for cost control. Such scale is also big enough to help lower production cost. However, lack of a distribution network is their biggest challenge in a new business area where competitors such as CP and Proconco & Anco have up to 3,000 and 2,000 agents, respectively. Moreover, CP also aims to expand their distribution network to 10,000 agents.

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We estimate that agri-food segment will contribute average VND3.5t revenue and VND197b p.a for HPG in the next four years given current disclosed capex.

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Recommendation History

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VCSC Information

VCSC Rating System & Valuation Methodology

Absolute, long term (fundamental) rating: The recommendation is based on implied total return for the stock defined as (target price – current price)/current price + dividend yield, and is not related to market performance. This structure applies from 27 May 2015.
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Valuation Methodology: To derive the target price, the analyst may use different valuation methods, including, but not limited to, discounted free cash-flow and comparative analysis. The selection of methods depends on the industry, the company, the nature of the stock and other circumstances. Company valuations are based on a single or a combination of one of the following valuation methods: 1) Multiple-based models (P/E, P/cash flow, EV/sales, EV/EBIT, EV/EBITA, EV/EBITDA), peer-group comparisons, and historical valuation approaches; 2) Discount models (DCF, DVMA, DDM); 3)Break-up value approaches or asset-based evaluation methods; and 4) Economic profit approaches (Residual Income, EVA). Valuation models are dependent on macroeconomic factors, such as GDP growth, interest rates, exchange rates, raw materials, on other assumptions about the economy, as well as risks inherent to the company under review. Furthermore, market sentiment may affect the valuation of companies. Valuations are also based on expectations that might change rapidly and without notice, depending on developments specific to individual industries.

Disclaimer

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